After Greenspan, What Standard?

President Bush reappointed Alan Greenspan as chairman of the Federal Reserve Board last May. The board is made up of seven members nominated by the president and confirmed by the Senate to fill 14-year terms (even the chairman must fill one of these seven seats). Members may serve only one full term. If a member is appointed to fill an unexpired term, he may be reappointed to a full term.

Most members of the Fed do not serve a full 14 years. Greenspan, however, was first appointed in 1987 to fill a seat that had a little less than five years remaining. He was then reappointed in 1992 to fill a full 14-year term. As a result, despite the fact that he has now been reappointed to a fifth four-year term as chairman, he must step down as a member when this term expires on February 1, 2006.

At that point, the president will be forced to appoint a new chairman. This will be a huge decision. Chairman Greenspan has depths of experience rarely seen in Washington. He has become one of the most effective politicians the capital has ever seen. He has cultivated relationships in every nook and cranny of government. Queen Elizabeth made him an honorary Knight Commander of the British Empire.

What few detractors he may have accumulated cannot find a toehold for support. World leaders seek his advice on topics that have nothing to do with monetary policy, and it is reported that he has a virtual veto on any appointments to the Fed Board. No other chairman has garnered so much power.

A NUMBER OF GREAT things have happened during his tenure. He ended years of frustrating secrecy and began an era of transparency at the Fed. In the mid-1990s, the Federal Open Market Committee (FOMC) — a group that includes all Fed governors and a rotating group of five regional bank presidents — started to release a statement following each meeting. This statement informs the market of the Fed’s thinking.

On the economic side of the ledger, it is hard to find fault in the overall picture of the economy during the reign of Sir Alan. During his 17 years, the economy has been in recession for just 16 months (8 percent of the time). In the previous 17 years, between 1970 and 1987, the economy was in recession for 49 months (24 percent of the time). Inflation, which averaged 6.5 percent annually in the 17 years before Greenspan, has averaged just 3.1 percent during his tenure.

Former Fed Governor Wayne Angell once said that he would judge his tenure on the Fed a success if the price of gold were no higher when he left than when he arrived. Judged on this Angell standard, the chairman is a winner. Gold was selling for $457 an ounce in August 1987 when he was first appointed. Today it is trading near $385 an ounce, a drop of roughly 1.0 percent per year.

With an economic performance like this, it is easy to see why so many politicians refuse to question Fed policy. But even more impressive is how the Fed has evaded any serious inquiry into its mistakes. The real Teflon-Man in Washington, D.C. is Alan Greenspan.

WHILE GOLD PRICES HAVE fallen during the Greenspan era, this long-term trend misses some dramatic movements in the past eight years. The price of gold was $410 an ounce in 1996, but fell to $256 an ounce in 2001. While many Fed officials insist that the price of gold is not a good indicator of general inflationary pressures, falling gold signaled the onset of deflationary pressures between 1999 and 2002.

Deflation can only be caused by one thing — excessively tight monetary policy. Yet, the Fed was able to avoid any blame for deflation, with most members of the financial press blaming it on China, productivity growth, and 9/11.

Since bottoming in 2001, the price of gold has climbed sharply. Those who watch gold and commodity prices have not been surprised that inflationary pressures are on the rise. So far this year, the consumer price index has climbed 5.1 percent at an annual rate, while the “core” CPI has climbed an annualized 2.9 percent. Inflation rates like these in the early ’70s led the Nixon administration to impose wage and price controls.

As a result of the sharp increase in inflation this year, the Fed shifted gears quickly. Just last March, the Fed was still arguing that deflation was a greater risk than inflation. It also thought that the upside and downside risks to economic growth were equal. In other words, the Fed was worried that both a recession and deflation were still possible. As a result of these statements, investors drove interest rates down dramatically and assumed that the Fed would not hike rates until 2005.

But job growth accelerated sharply (adding 947,000 in just three months) and inflation jumped. These developments were in direct contradiction to the Fed outlook. In a few short weeks, the markets have responded dramatically. Ten-year Treasury yields surged by more than a full percentage point and the markets now expect the Fed to double the federal funds rate by the end of the year — to at least 2.0 percent.

Such abrupt shifts in the direction of monetary policy send shockwaves through the financial system that can cause a great deal of damage. Following a period of excessive accommodation in monetary policy in 1992 and 1993, the Fed pushed the federal funds rate up sharply (from 3 percent to 6 percent) in 1994. Financial market problems snowballed. The Mexican peso crisis, the Orange County bankruptcy, huge losses at the investment bank Piper Jaffray, and incredible stress on the financial system all occurred in the wake of those Fed rate hikes.

In 1999 and 2000, despite falling gold and commodity prices, an inverted yield curve, and a very strong dollar, the Fed boosted the federal funds rate. The result was a stock market crash, recession, and deflation. Bankruptcies spread rapidly and the financial system seized up, even before 9/11. The Fed responded by cutting rates 11 times in 2001 — one of the most dramatic series of rate cuts in U.S. history.

The Fed has now moved to its most inflationary policy stance since the late 1970s. China, which pegs its currency to the dollar, and therefore accepts Chairman Greenspan as its central banker, has seen a complete reversal of fortunes. It experienced painful deflation between 1999 and 2002, and is now experiencing enough inflation to compel dramatic credit tightening by the central government.

THIS VOLATILITY IN MONETARY policy is damaging to any economy. More to the point, it is unnecessary. The main reason for these sharp swings in interest rates is that the Fed seems to follow what the Wall Street Journal dubs “The Greenspan Standard.” This standard seems to flow from the forecasts of the chairman himself.

Looking back at the arguments used by the Fed to justify its policy shifts, there is no consistent framework. In the late 1990s, the Fed argued that “insecure workers” were holding back wage growth and therefore the true inflationary impulse of the economy was hidden. During that same period of time, Greenspan was supposedly an early convert to the idea that productivity growth had accelerated, and inflation would remain subdued. These arguments, however, were contradictory.

But then in February 2000 Greenspan took an unexpected turn. He argued that strong productivity growth actually caused higher inflation. His theory went like this: Strong productivity growth boosted estimates of corporate profits and pushed up the stock market. A rising stock market caused a wealth-induced boom in consumer spending that exceeded supply. With aggregate demand growing faster than aggregate supply, inflationary pressures would increase.

The only problem with this “productivity causes inflation” argument is that there is absolutely no economic theory to back it up. In fact, the Fed found no support whatsoever for this argument from the economic community at large and never repeated the argument again. However, this did not stop the Fed from increasing interest rates anyway.

IN RETROSPECT, IT APPEARS THAT Chairman Greenspan was making up new economic arguments to justify the actions that he had already decided were appropriate. This is why it is easy to call it “The Greenspan Standard.”

There are at least two problems with this state of affairs. First, because Greenspan alone understands this standard, whoever replaces him will by definition have a different standard. Second, there is no legacy for managing Fed policy. These are both destabilizing issues. If, when a new chairman is appointed, the Fed changes along with that appointment, there is no guarantee that policy will remain consistent.

To avoid volatility in monetary policy, the Fed should institute a price rule for monetary policy and target inflation rather than unemployment, GDP growth, or stock prices. The best way to do this is to follow sensitive market prices such as the dollar, commodity prices, and gold. These markets react to monetary policy well before consumer price inflation and do not suffer the same measurement problems as lagging economic indicators, such as the labor market or capacity utilization.

As the president begins to think about who might replace Greenspan in 2006, continuity and stability in policy should be the number one issue. And the only way to guarantee this stability over time is for the president to appoint someone who believes in a price rule for money and does not count on a cult of personality to defend the institution. Steve Forbes, Larry Kudlow, and David Malpass would all fit the bill. There are less than two years to lay the groundwork. It is time to start now.